Understanding Hedge Fund Strategies: Emerging Markets Fund

moscow-hedgethink Understanding Hedge Fund Strategies: Emerging Markets Fund

This is a type of hedge fund whose strategy involves specialist investment in the securities of emerging market countries. These mutual fund or exchange-traded funds may invest the majority of their assets in the financial markets of a single developing country or a group of developing countries. At the moment, these countries tend to be in Eastern Europe, Africa, the Middle East, Latin America, the Far East and Asia.

What do we mean by Emerging Markets?

There isn’t an exact definition of ‘emerging market’, but they are countries that can be described as ‘developing’. While they remaining in this developing stage, they can be vulnerable to economic instability, as well as political instability. Being in the process of building their commercial and industrial sectors, they tend to have low average per-capita income, and are moving towards an open market from a closed one.

The term ‘emerging markets’ is one that’s been coined by the investment community to mean a clutch of developing nations that offer superior growth prospects. These countries do offer the potential for higher rewarding investment opportunities – however, investment in these countries can come with a relatively high risk.

Examples of Emerging Markets

As there is no specific definition of an emerging market country, the category encompasses a wide array of nations. There’s big-hitting China and Brazil, which even amateur investors will have heard of through the news and media as countries that are developing at a pace. And there are up-and-coming regions that are more off-radar that are attracting increasing investment too, such as Indonesia and parts of Africa.

As a result of the lack of any strict definition, far larger, more developed countries like Russia and China, are lumped together under the ‘emerging markets’ banner along with countries like Peru. While Peru may be far smaller, with fewer resources, like China and Russia it has embarked on reform programs and has made moves towards developing its economy more in line with Western open markets recently, thereby ‘emerging’ out onto the global financial scene.

Currently, around 20% of the countries in the world are categorized as emerging markets. However, these countries account for around 80% of the world’s population.

Frontier Markets

‘Frontier Markets’ are another area of emerging market-like investment. These are regions that aren’t yet defined as being either developed or emerging. In essence, they are nascent, and far smaller and harder to access than the bigger emerging markets such as Brazil. They tend to have fewer companies available to invest in, and are far more likely to be more risky regions to invest in, due to higher potential for political unrest. These markets include parts of the United Arab Emirates, Saudi Arabia and Nigeria. Some funds are now increasingly moving into the area of frontier markets. The reason? The MSCI Frontier Index is up over 20 per cent so far this year, while the MSCI Emerging Markets Index has seen a slight fall.

Emerging Market Mutual Funds

Recently emerging market mutual funds have boomed in popularity, attracting investors from a range of sectors, including institutional investors, pension funds and endowments. Even those in the UK looking to invest their ISAs this year are looking to emerging markets for potential income growth. These differ from emerging market hedge funds, and have actually existed for some time, but it’s only now that we’re beginning to see an increased level of investor confidence in these types of funds.

Emerging Market Hedge Funds vs. Emerging Market Mutual Funds

The way these two types of emerging market funds differ is in the strategies they employ and the securities they choose to invest in. Mutual funds tend to invest only in bonds and stocks. However, hedge funds allow investment in a far wider reaching scope of securities, including more sophisticated investment routes into currencies, commodities, real estate, and derivatives. Derivatives, which are contracts to purchase or sell other securities at specified prices, include options and futures too. So we can see, for the investor, that hedge funds open up a far wider potential portfolio for emerging market investment.

Another advantage that the hedge funds hold over the mutuals is that they can use leverage in their emerging market investments. This, combined with the wider array of investment opportunities, means that hedge funds in emerging markets can offer significantly higher potential returns.

Potential pitfalls

General risks – As you will have learned, any type of investment that promises higher potential returns also comes with the potential for increased risk. Emerging market hedge funds are no different. These risks include those typical of almost all hedge funds: a lack of liquidity making it more difficult to sell shares, strategies implemented could lead to marked losses, and as these markets involve a high level of information gathering and skill in which to invest, fees for fund investors can be high.

Unique emerging market risks – However, emerging markets hedge funds come with a few additional risks of their own, specific to the chosen strategy of investing in developing nations. There is relative illiquidity to contend with, as well as a lack of transparency. This can make it hard for funds to gain a true grasp of investment opportunities, risks and problems about to reach boiling point in their chosen investment regions. As developing nations are more vulnerable to economic and political instability, it means that these investments are at risk of extreme volatility too.

Aggravated downturn risks – Additionally, there is a self-propagating effect that emerging market investments are susceptible to that can pose another significant risk to fund investors. Should hedge fund investors face a downturn in one emerging market country, if they then demand their money back, hedge funds can be forced to sell holdings in other markets that are unaffected in order to meet redemption requests. This can lead to a far steeper slide in regions that weren’t originally affected.

Lack of regulation – For investors looking for a low risk vehicle, emerging market funds share another downside that can put investors’ money on shaky ground. Like all hedge funds, emerging markets hedge funds are not currently regulated by the U.S. Securities and Exchange Commission (SEC).

Who can invest?

This lack of SEC oversight also means that emerging markets funds aren’t open to everyone, only to a limited range of investors. U.S. laws require that hedge fund investors be ‘accredited’, and this means they must have a net worth of over $1 million, and be experienced investors who earn a minimum annual income.

To sum up, if you’re an investor looking to get into the emerging markets, but want more access to these markets that mutual funds can offer, then emerging markets hedge funds are the answer. But they are only an option for those investors who qualify – and for those who are willing to face up to the increased risks inherent in investing in developing economies.